Do you look up to people who are extremely confident?
While being confident has its advantages, overconfidence comes with its set of disadvantages as well.
It is especially true when we look at the impact of overconfidence on our investment decisions.
Overconfidence is a common behavioral bias that causes people to make hasty investment decisions.
In this article, we explore the effects of overconfidence on investment and personal finance, explaining how even the most intelligent people can become victims of overconfidence bias and, more crucially, how to steer clear of them.
Overconfidence Bias: What Is It?
A person may suffer from overconfidence bias if they have an inflated sense of their own knowledge or exceptional abilities in areas such as investments.
Investors with overconfidence bias generally form this bias in the course of their investment journey. They might have struck gold with a few of their stock picks or they might have been able to correctly time the entry and exit of a particular investment option.
This might make the investor overconfident about his or her investment abilities.
Take this example.
In a study, it was found that 73% of people insisted that they are better drivers than average drivers. Obviously, not everyone is right.
But this shows us that we tend to overestimate our abilities.
If you believe that you can consistently beat the market, then you might be a victim of overconfidence bias as well.
How Overconfidence Affects One's Financial Situation And How To Overcome It
Now, let us look at how overconfidence bias might affect your financial situation.
1) Not Managing Their Risks Properly
Far too many people let their emotions, rather than logic, guide their risk tolerance assessments. Some people think they can ride out market volatility or downturns, but then they sell their investments in a panic and lose a lot of money. Hence, it is important to understand your risk tolerance before you make any major investment decisions.
2) The F&O Trap
Professionals, like doctors, often fall prey to the allure of high returns in Futures and Options (F&O). In my personal experience, I have seen a lot of doctors who believe that they can easily carry out F&O trading and get handsome profits on a consistent basis.
But sooner or later, they get their fingers burned. It is important to understand that being a doctor or any profession that requires years of rigorous training doesn’t automatically equate to being a good trader.
Instead of being overtly overconfident on your gut feelings, it is important to be practical and ask questions like:
Do I have the time to focus on F&O trading all the time?
Do I have adequate investment experience to start F&O?
If any one of the answer is NO then F&O might not be the right option for you.
3) Excessive reliance on external sources
Most of the time, persons who overestimate their future profits or market performance end up borrowing too much money or investing on margin. They have to deal with debt or sell off assets when the predicted windfall doesn’t come through. Hence, it is important to use one’s income for investment purposes.
4) Making a rash investment
When people are overconfident, they sometimes make rash investing decisions without doing their homework, such as buying equities that are currently trending up in price or putting all their money into industries that have shown recent growth. While you might be lucky but it is highly unlikely that you will be right all the time.
5) Ignoring Professional Guidance
It is common for individuals who are overconfident to disregard the recommendations of their financial advisors because they believe that their own judgment is superior. As a result of this do-it-yourself attitude, portfolios may not be adequately diversified, and opportunities may be lost.
How to Overcome Overconfidence Bias
In the previous paras, we have already discussed a few ways to overcome overconfidence bias, here are a few more ways to make sure that you don’t fall victim of overconfidence bias.
- Accept and appreciate humility: Be aware of the constraints of your knowledge and acknowledge that markets are unpredictable. Even investment guru Warren Buffett said to stick to familiar things.
- Enhance Investment diversification: Avoid placing all of your eggs in a single receptacle. Diversify investments geographically and across asset classes to mitigate risk.
- Conduct a Pre-Mortem Analysis: Inspired by Nobel Laureate Daniel Kahneman, this approach entails the creation of both success and failure scenarios for your financial plans. Identify potential hazards by assessing what could go awry.
- Opt for the advice of a professional: Financial advisors can assist in diversifying your portfolio, keeping emotions in control, and providing a balanced perspective.
- Conduct routine inspections of performance: Periodically assess your investment strategies. Adopt a more reflective approach and learn from your past errors.
- Automate Investments: Instruments such as systematic investment plans (SIPs) mitigate emotive decision-making, thereby encouraging discipline and the accumulation of long-term wealth.
Conclusion
Overconfidence bias can feel like a hidden superpower, encouraging risky financial decisions and a sense of control. However, in terms of personal finance and investments, it is more of a concealed trap. Individuals who overestimate their knowledge and ignore risks may unintentionally jeopardize their financial security.
The key to overcoming this is awareness and discipline. Take some time to think about your options, consider different points of view, and seek help when necessary. Remember that managing money isn’t about demonstrating how much you know—it’s about creating a future in which your financial aspirations match your reality.
Prasad Iyer
[Certified Financial Planner – CFP CM]
